The Foreign Service Journal, January-February 2021

62 JANUARY-FEBRUARY 2021 | THE FOREIGN SERVICE JOURNAL AFSA NEWS Investments in Real Estate Taxpayers generally invest in real estate in four scenarios: Scenario 1: To live in as their personal residence. Scenario 2: For use as a vacation home. Scenario 3: To live in as their personal residence, but may rent it out at times when not living in it. Scenario 4: To rent to a third party strictly for investment income purposes with no personal use. Adjusted Basis In all four scenarios, it is important to properly calculate the adjusted basis of the property. Please refer to Tax Topic 703; Publication 551; Form 1040 Schedule D with instructions; IRC Sections 1011, 1012 and 1014 through 1017; and associated tax regulations beginning at 26 CFR Sec. 1.1012-1. Recent iterations of the annual tax seminar offered by the Foreign Service Insti- tute have illustrated how mistakes in tracking basis can result in incorrectly calculated depreciation of rental properties and incorrectly reported gain or loss from the sale of real estate. Scenario 1: Personal Residence Never Rented While living in the property as a personal residence, a taxpayer may deduct mortgage interest and property taxes as an item- ized deduction on Schedule A, subject to limitations. Note that current tax law allows a taxpayer to deduct mortgage interest up to current mortgage limits ($750,000 unless the mortgage meets the requirements for grandfathered mortgage limit of $1 million) for up to two properties, a personal residence and a second home personally used by the taxpayer. Scenario 2: Vacation Home A vacation home is a second home aside from your personal residence that may be used by you for vacationing and may be rented out at times during the year. If you use the vacation home without renting it out, you may deduct the mortgage interest and property taxes on Schedule A, subject to limits as described in Scenario 1. If you rent out your vacation home for less than 15 days during the year, you are not required to report the rental income on your tax return and you may still deduct the mortgage interest and taxes on Schedule A. If you rent the vacation home out but use it personally for the greater of 14 days or 10 percent of the number of days rented, it is considered a personal residence and you may not deduct rental expenses greater than rental income. Mortgage interest and real estate taxes allocated to personal use are reported on Schedule A, subject to limitations. Mortgage interest, real estate taxes and other deductible expenses (including depre- ciation) allocated to rental use are reported on Schedule E using the vacation home rules. Scenarios 3 and 4: Rental Property Real estate that you purchase as a personal use home and then convert to rental status (or vice versa) and real estate that you purchase for immediate rental to a third party both have similar requirements for calculating depreciation during the rental period and for capital gain or loss calculations upon sale. During periods when the property is rented, the taxpayer must report the gross rental income received and deductible expenses on Schedule E. Please review the annual Foreign Service Institute Tax Seminar presented each February (available online at https://bit.ly/fsi-tax-seminar) for complications to consider when deciding which expenditures are immediately deductible and which expenditures must be capitalized and depreciated during rental use. Depreciating Real Property Used to Produce Income During periods when real estate is rented, the IRS requires the taxpayer to depreciate the property over the IRS-defined recovery period. To calculate annual depreciation, a taxpayer must know: (1) the property’s adjusted cost basis and fair market value at time of rental conversion (the taxpayer must use the lower of the fair market value or adjusted basis as the depreciable basis); (2) adjustments to basis (tracked throughout the life of the property); (3) the date the prop- erty was placed in service as income-producing; and (4) the IRS-mandated depreciation method and convention. The IRS requires a taxpayer to depreciate buildings, certain land improvements and other types of capital assets—all annually. The IRS, however, prohibits a taxpayer from depreciating land, including the land on which a depreciable asset sits. So, land values must be accounted for separately. Property used for personal purposes may not be depreciated and claimed for tax purposes. Taxpayers who believe they have sufficiently documented their property to begin using it for income-producing purposes should contact a tax professional to properly set up the prop- erty for tax reporting purposes, calculate deductible expenses (including depreciation), account for income derived from the property, and file correct tax forms on time each year. Failure to include the proper amount of depreciation on the Schedule E Circular 230 Notice: Pursuant to U.S. Treasury Department Regulations, all tax advice herein is neither intended nor written to be used, and may not be used, for the purposes of avoiding tax-related penalties under the Internal Revenue Code or promoting, marketing or recommending advice on any tax-related matters.